The Heavy Price of Stockpicking

If the pros can't get it right, wealth manager Eric Nelson asks, what's the chance that a do-it-yourself investor will do any better?

By Gil Weinreich|July 08, 2013 at 10:32 AM

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The tab for speculating in the stock market is about 4% a year, according to the calculation of one influential wealth manager. That’s a harsh penalty to pay when the S&P 500’s average annual result over the past 15 years is barely above that amount, at 4.28%.

The Oklahoma City-based registered investment advisor and Dimensional Fund Advisors loyalist starts his analysis at the professional money manager level, arguing that their performance as measured against indexes shows they lack market-beating skill.

Unlike top athletes or surgeons who demonstrate superior abilities, Nelson’s scorecard reveals that just 20% of fund managers beat their index from 2008 to 2012 and that the number who did so in most categories closely matched the number of mutual funds that were outright closed “due to horrendous underperformance.”

For example, 24.6% of active large-cap funds beat their index during that period, while 27.7% of active large-cap funds were shut down. The category that exhibited the least correspondence was not to the credit of professional managers: Just 9.6% of active short-term bond funds beat their index—far less than the 21.7% of such funds that closed during that period.

Nelson attributes manager selection to a Lake Wobegon mentality that assumes their manager is better than average. Yet he argues that people select their better-than-average managers based on past performance that doesn’t persist.

Nelson cites data from Standard & Poor’s showing the performance of the top managers from 2003 to 2007 in the subsequent five-year period from 2008 to 2012. Just 24.1% of top quartile managers remained in the top quartile, whereas 19.3% fell to the second quartile, 20.3% to the third quartile and 23.1 dropped to the last quartile; the missing 13.3% lost their jobs as their funds were shut down.

The wealth manager concludes: “So even when narrowing the search for a professional active manager to only those who have previously produced the best results, we still find the chance of future index-beating returns is no better than choosing at random (by chance, we’d expect to have 1/4 odds of landing in each of the four quartiles, and a bit less when we consider the odds of disappearing completely).”

Nelson notes there are actually greater odds (nearly 37%) of a top fund falling to the bottom quartile or disappearing than remaining in the top quartile (24%).

The professional advisor emphasizes that this poor performance emanates from people with chartered financial analyst (CFA) designation and Ivy League MBAs.

“If they can’t get it right,” he asks, “what is the chance that a do-it-yourself investor running a Charles Schwab or Morningstar stock screener for a few hours in the evening or on the weekends will perform better?”

Drilling down further, Nelson next takes a page out of John Bogle’s book, literally, and considers both the underperformance of active managers and bad investor behavior.

Bogle’s The Clash of the Cultures shows that large-cap funds returned 4.1% to investors from 1997 to 2011, compared with 5.4% for their S&P 500 benchmark. While the numbers are both small, Nelson points out that that means 37% less wealth over 15 years for active fund investors, and 72% less wealth over the same time period compared to the wealth managers’ clients invested in his favorite DFA US Large Value Fund (DFLVX).

“But even this dismal result is too generous,” Nelson says, since naughty investors typically dump poor-performing funds for those with recent good performance, which subsequently perform poorly, which “amplifies the return deficit.”

“So between poor professional management and bad investor behavior, the total cost speculators pay is almost 4% per year!” Nelson says in summary, calling on investors to save their wealth through the discipline of a fee-only investment advisor.

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